Recent case law developments on indirect tax

On 22 June 2023 and 7 July 2023, Stewart J issued his judgements in “Hannover Life Re of Australasia Ltd v Commissioner of Taxation” addressing foundational issues of Goods and Services Tax (GST) recovery and apportionment. The principles considered are particularly relevant to taxpayers in the financial services and property sectors, and generally taxpayers who make both input taxed and non-input taxed supplies.

Given the issues decided in favour of the taxpayer, the Commissioner has appealed against the decision but the specific details of the appeal were yet to be made public. However, taxpayers making input taxed and non-input taxed supplies should review:

1. Their cost allocation approaches to ensure they are appropriate for GST purposes; and
2. The appropriateness of their apportionment methodologies (rather than simply refreshing existing methodologies with current year data) to ensure they are fit-for-purpose and documented appropriately.
3. Insurers, in particular, should have regarded all of their activities, including investment activities, in determining their apportionment methodology.

Key takeaways

Cost allocation

1. The Commissioner is increasingly scrutinising cost allocations for GST purposes as a gateway to GST recovery and a prerequisite step to apportionment. Determining whether an acquisition relates to making supplies that would be input taxed, needs to consider contractual frameworks and not just commercial context, which can be misleading for GST. Taxpayers also need to ensure that identified relationships arising “by and through” initial input taxed supplies are disregarded, and consistent with the principles outlined in Rio Tinto¹.
2. The Commissioner was unsuccessful in arguing (and we consider has likely appealed) that costs should only be allocated to supplies if they relate to making those supplies. Taxpayers should clearly document the basis of any identified relationships between acquisitions and supplies, including how acquisitions relate to making relevant supplies.
3. Cost allocation methods should be reviewed to ensure they consider all supplies being made by the enterprise. Where direct allocation of acquisitions to a single supply is not possible, it may be necessary to establish multiple overhead cost pools where overhead costs may relate to supplies differently. Furthermore, a single overhead cost pool may not be appropriate.

¹ Rio Tinto Services Ltd v Federal Commissioner of Taxation [2015] FCAFC 117; Rio Tinto Services Ltd v Federal Commissioner of Taxation [2015] FCA 94.

Reliance on statutory (or similar non-tax) cost allocation methodologies

1. Cost allocation methodologies used for accounting, statutory, or regulatory purposes can provide a useful starting point to determine GST recovery, but they may require modification to address GST-specific considerations. For example, supplies made for no consideration or financial acquisition—supplies may not be captured by revenue or capital adequacy-based cost allocation approaches used for statutory or accounting purposes.
2. Departures from business-accepted cost allocation methodologies can give rise to additional considerations, such as tax coding/mapping in systems, and ownership of additional GST costs/recoveries as part of internal reporting that needs to be managed.

Apportionment methodologies

1. Apportionment methodologies must reflect consumption of relevant acquisitions/cost pools and incorporate all relevant supplies for GST purposes, not just transactions driving profitability. The design of a methodology should therefore carefully consider the existence of intermediate transactions that are relevant to overall commercial outcomes.
2. The decision arguably departs from previously commonly adopted principles about the fair and reasonable design of apportionment methodologies. Elements of the decision perhaps, seems to conflict with earlier analysis on the judgement concerning commissions about cost allocation being based on contractual frameworks. Taxpayers should therefore make careful consideration and seek guidance before amending apportionment methodologies in response to the decision.
3. Commonly used apportionment drivers, such as revenue or time, should be reviewed to ensure they are appropriate to the costs and operations of the relevant area. When using proxies such as revenue, we would suggest ensuring that all supplies made (in a GST context) are being considered. Any updates or changes to the cost allocation and apportionment processes should be sufficiently documented in terms of the connection to supplies of the enterprise.

Summary of background facts and GST issues

Hannover Life Re of Australasia Ltd (Hannover) is a GST-registered life insurance company regulated with the Australian Prudential Regulation Authority (APRA). Its main revenue generating activities comprise:

• underwriting life insurance policies to resident policyholders in Australia, which were distributed by Greenstone Financial Services Pty Ltd (Greenstone);
• providing reinsurance for life insurance policies to other Australian life insurers; and
• providing reinsurance to its New Zealand branch for life insurance policies.

For capital adequacy reasons, 75% of all risk insured/reinsured by Hannover, together with corresponding net premiums received in relation to the risk, was transferred to Hannover Rück SE (Hannover Rück), a related non-resident entity, under a separate agreement with Hannover. Without the reinsurance arrangement with Hannover Rück, Hannover would not have been able to write relevant insurance or reinsurance policies. However, the respective insureds or primary insurers had no contractual rights against Hannover Rück as their primary contracts were solely with Hannover.

For GST purposes:

• the underwriting of life insurance policies and provision of life risk reinsurance to Australian policyholders/insurers is an input taxed supply, which generally prevents the recovery of GST incurred on associated expenses;
• the provision of life risk reinsurance to its New Zealand branch is a GST-free supply. The reinsurance arrangement with Hannover Rück was agreed between the parties to be a GST-free acquisition-supply by Hannover². Entities making GST-free supplies (including acquisition-supplies) are entitled to recover in full any GST incurred on associated expenses; and
• an entity must first attempt to allocate acquisitions between the input taxed and non-input taxed supplies it makes. Only if an acquisition does not wholly relate to a particular input taxed supply or a non-input taxed supply, the entity would then need to determine the appropriate GST recovery using a fair and reasonable apportionment methodology.

The key issues were:

1. Whether the cost allocation approaches used by Hannover were appropriate in determining whether GST could be recovered in respect of the following expenses:
   a. Commissions paid to Greenstone; and
   b. Overhead expenses relating to Hannover’s overall operations.
2. Whether the apportionment methodology used by Hannover to determine GST recovery was fair and reasonable, with regards to Hannover’s acquisitions related to making both input taxed and non-input taxed supplies.
   

² The aquisition of a financial supply is also treated as a supply for GST purposes in accordance with Division 70 of the GST Regulations.

Summary arguments and outcomes

Distribution arrangement

The taxpayer submitted that the distribution services acquired from Greenstone had a real and substantial relationship to both the provision of life insurance policies and the corresponding reinsurance arrangement with Hannover Rück, such that 75% of the GST incurred should be recoverable as relating to the Hannover Rück reinsurance acquisition-supply. As justification for this position, Hannover observed that without the reinsurance support it would have had insufficient capital, and therefore not be able to comply with its prudential requirements to issue relevant risk policies. As such, the initial provision of life insurance and the subsequent reinsurance arrangement were closely linked.

This was not accepted by Stewart J, who agreed with the Commissioner’s reliance on principles established by Rio Tinto Services Ltd v Federal Commissioner of Taxation [2015]. Namely, the ‘necessity’ of an acquisition to the making of a supply is not a test in determining creditable purpose. Furthermore, the connection between an acquisition and an input taxed supply is not reduced by a relationship between the acquisition and a subsequent non-input taxed supply, where the non-input taxed supply is made by and through the input taxed supply.

In the current case, Stewart J concluded that there was no connection between the acquisition of the distribution services and supplies made as part of the reinsurance arrangement, as the reinsurance arrangement was made by and through the input taxed supplies of issuing relevant life risk policies. Emphasis was placed on the contractual relationships between Greenstone, Hannover, and Hannover Rück to determine the existence and cascading of any relationship between relevant acquisitions and supplies. On this basis, Stewart J ruled that the Greenstone services were related solely to Hannover’s input taxed supplies of life insurance policies, and therefore were not made wholly for a creditable purpose.

Overheads

While the Commissioner agreed with Hannover’s allocation of overhead costs to both its supplies of life insurance and reinsurance, he disagreed that the overheads were also related to Hannover’s reinsurance arrangement with Hannover Rück. Specifically, the Commissioner considered the costs as not related to making the relevant acquisition-supplies and if they did, the basis of cost allocation was not appropriate.

The Commissioner submitted that the overheads should be assessed as two distinct categories:

1. acquisitions that allow employees to perform their work (e.g., rent, information technology, office supplies, telephone, and office expenses), and
2. other acquisitions relevant to operations that did not assist the employees to perform their work (e.g., audit, consulting, and advertising).

For the first category, the Commissioner submitted that work done by an employee in relation to the reinsurance arrangement was by and through the life insurance and reinsurance policies issued by Hannover, and did not relate to activities undertaken by employees in making supplies as part of the reinsurance arrangement. Accordingly, the reinsurance arrangement with Hannover Rück should not be included in any relevant apportionment methodology. However, this was rejected by Stewart J, who determined that the overheads did not have any immediate connection to initial life insurance or reinsurance policies issued, therefore their overhead nature should indifferently relate to all relevant supplies as contended by Hannover.

The Commissioner sought to argue that there was no positive relationship between the acquisitions and the relevant GST-free supply to warrant the GST-free supply’s inclusion in a cost allocation methodology, Stewart J contends with no sufficiency of nexus to identify input taxed supplies to limit allocation to all supplies made.

The Commissioner also submitted that if a relationship was established between the first category of acquisitions and the reinsurance arrangement with Hannover Rück, the apportionment methodology was not appropriate as there was insufficient evidence to identify how much work was done by the employees in relation to the reinsurance arrangement. This argument was rejected by Stewart J notwithstanding the scarcity of evidence, but he observed that the use of undifferentiated time spent may not be an appropriate basis of apportionment for GST purposes, despite being an accepted method for statutory allocation. Stewart J commented:

“The statutory expense allocation is done using employee hours as the relevant proxy... that does not make it the necessary proxy for the creditable acquisition allocation when the supplies with Hannover Rück are concerned. The key difference between the statutory expense allocation exercise and the exercise of apportioning partly creditable acquisitions is that the former takes into account only the revenue earning output of the enterprise as expressed in its statutory funds... [the] latter exercise – apportioning partly creditable acquisitions – must take into account all supplies, which include the acquisition supplies from/to Hannover Rück which do not find expression in a statutory fund and which are undertaken at a net expense to the enterprise.”

The Commissioner also submitted that the second category of overheads acquisitions did not have a relationship with the reinsurance arrangement other than by and through the life risk and reinsurance policies issued (as contended for the first category). This was rejected by Stewart J based on the evidence provided. However, Stewart J expresses his surprise that this characterisation of advertising was not challenged under cross-examination by the Commissioner, observing that the advertising expenses were unlikely to be incurred in relation to the reinsurance arrangement.

In summary, Stewart J agreed that Hannover was entitled to allocate a portion of its overhead costs to the reinsurance arrangement with Hannover Rück. Despite the agreed facts regarding overhead costs related to policies written by Hannover, the decision lends support to the approach that where overhead costs are accepted as overheads for business and commercial purposes, it is reasonable to conclude that overhead acquisitions require apportionment in respect of the relevant department or business.

Apportionment

Hannover’s apportionment methodology, a combination of statutory expense allocation and premiums paid/received, was challenged on the following three basis:

1. The Commissioner considered the methodology proposed as not appropriately reflecting the totality of input taxed and non-input taxed supplies made. However, Stewart J accepted that the methodology proposed was reflective of the business risk.
2. The Commissioner submitted that the methodology used did not consider investment-related input taxed supplies made by Hannover on net premiums retained. This was accepted by Hannover and the parties were directed to reach an agreement on a revised methodology, which they did confirmed in the subsequent hearing on 7 July 2023.
3. The Commissioner submitted that the prior year’s data should have been used, rather than current year, given that the data would not have been available to Hannover on a real-time basis.

To illustrate his primary argument, the Commissioner observed that if 100% of the risk insured by Hannover were reinsured by Hannover Rück, Hannover’s methodology would not produce a fair and reasonable outcome, as Hannover would be entitled to recover GST in full on related overhead costs. Stewart J disagreed, considering that the outcome would be fair and reasonable as it aligned with the enterprise’s revenue outcome if 100% of the risk was reinsured by a non-resident counterparty.

It is arguable that this approach is inconsistent with the preceding analysis relating to the Greenstone commissions where Stewart J observed that it is necessary to identify the contractual framework in which supplies were made and that all relevant supplies should be considered. However, the methodology accepted has the effect of disregarding the primary input taxed supply made when taken to an extreme. Stewart J’s findings were also inconsistent with common industry practice where a value of supplies approach had been adopted, which determines input taxed supplies as a proportion of all supplies made. Given this departure from documented guidance and the potential implications, we expect this issue will form part of the Commissioner’s appeal.

The Commissioner also challenged Hannover’s use of contemporaneous-year data when performing calculations for historical periods. The Commissioner contended that a relevant year’s data would only become available the following year (assuming an annual refresh), and thus it would not be appropriate to use current year data when undertaking a historical exercise. Stewart J disagreed with this, noting that it was intended to be a proxy and if the data were available, only then it could be used. In our view, the conclusion is reasonable and should not come as a surprise to taxpayers who have undertaken historical apportionment adjustments.

For further information, please contact Andrew D’Addona.